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Equities

The Power of Compounded Income

2019 October - 7 min read

Over 10 years into an economic recovery, we’ve continued to see new highs in equity indexes. In this Q&A, Darryl Lucas explains how a focus on resiliently growing companies, coupled with the power of compounded dividend and profits growth, can lead to strong returns over time.

At a time when rates are low—and seemingly poised to move lower—the search for yield continues. In this environment, what role can equities play in an investor’s portfolio? 

Equities can deliver attractive returns, particularly over the longer run. For example, $1000 invested in the S&P 500 in 1988, would, over the following 30 years, have accumulated to approximately $20,000 (Figure 1). Equities can also deliver something rather unique, which is growth of both income and capital over time. 

However, the trouble with equities is that they don’t deliver these returns in a straight line. Equity sits at the bottom of the capital structure, which means investments are more prone to sharp drawdowns, as we have seen on several occasions over the past three decades. When these drawdowns occur, investors, understandably, tend to panic and exit the market completely. One never knows precisely when the rout will stop, but disinvesting from equities is also fraught with danger, though of a different type: the opportunity cost of not being invested. Going back to the example of $1,000 invested in 1988—if an investor had been unlucky enough to have missed the best 10 days (by highest return) over the 30-year period, their return would have been approximately halved, so generating a c.$10,000 sum rather than the c.$20,000 had they remained fully invested.

FIGURE 1: DIVIDENDS ARE A SIGNIFICANT COMPONENT OF LONG-TERM TOTAL RETURNSFIGURE 1: Dividends are a Significant Component of Long-Term Total ReturnsSOURCE: Bloomberg, Barings. As of August 31, 2018.

A potential solution for long-term investors, therefore, may be to invest in an equity strategy that is designed to mitigate risk during periods of market weakness, while retaining characteristics that could see the strategy outperform broader equity indexes over the long run. In our view, one way to effectively do this is by investing in a carefully curated selection of resilient, growing and predictable businesses. This is what we aim to do within our Global Dividend Champions strategy.

And dividends really do matter—although 10 years into a bull market, very few investors are actually speaking about them. With this in mind, we look for companies that can deliver an attractive dividend growth trajectory over time—10% compounded annual growth is what we broadly target at a strategy level—which means an investor could potentially double their income stream every seven years.  

With this in mind, what types of companies fit well within this strategy?

There are three things in particular that we are trying to achieve with our Global Dividend Champions strategy: strong total returns, an attractive and growing income stream over time, and a lower risk profile versus broader equities. On the third point, we specifically aim to lower potential drawdowns, not necessarily to minimize volatility—an important distinction.

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